Chicago Booth Review Podcast Is Atlanta a Better Real-Estate Investment than New York?

Joseph L. Pagliari Jr.: Some investors have redlined Chicago, meaning that they refuse to invest dollars here until there's a clearer financial picture.

Hal Weitzman: New York, LA, Chicago, Boston, and other big U.S. cities have traditionally been a good bet for real estate investors. Is that changing? Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking insights in a clear and straightforward way. I'm Hal Weitzman.

Today, Chicago Booth's Joe Pagliari explains why those traditional markets are riskier investments and why more and more real estate investors are looking at cities such as Atlanta, Dallas, Denver, and Houston. Joe Pagliari, welcome to the Chicago Booth Review Podcast.

Joseph L. Pagliari Jr.: Thank you very much. Delighted to be here.

Hal Weitzman: Now, you're an expert in real estate, of course.

Joseph L. Pagliari Jr.: Some say. Not many.

Hal Weitzman: Let's say you are. Otherwise, we haven't got a very good podcast. And we're here to talk about gateway markets in real estate. What do we mean by gateway markets?

Joseph L. Pagliari Jr.: So there are some differences of opinion in the industry, but generally, it lands on Boston; New York; Washington, D.C.; Chicago; San Francisco; and Los Angeles. So these are markets that are robust from a real estate standpoint. Lots of liquidity, considered knowledge centers. Oftentimes, there's a major research university associated with those cities, and there's some kind of major industry.

You can think about finance. You can think about the film industry. You can think about, oh, I don't know, the tech industry in Silicon Valley and San Francisco. So these markets are considered kind of the most stable or, at least up till recently, have been considered to be the most stable amongst our various geographic markets.

Hal Weitzman: Okay. Gateway to what? To real estate investing?

Joseph L. Pagliari Jr.: Yeah. I think gateway just comes from sort of this old-fashioned notion that ideas and new businesses flow from these gateway markets to the rest of the country.

Hal Weitzman: Okay. And so, does it basically translate to the big cities?

Joseph L. Pagliari Jr.: It does. Right? So, I mean, you could argue that Boston, for example, on a population basis is not very large. But in terms of business, education, advancement in terms of ideas, and all the rest, Boston ranks right at the-

Hal Weitzman: I think in the minds of the people who live in Boston, it's bigger than the whole United States, isn't it? Okay. So tell us, you're obviously thinking about institutional real estate investing. What is the conventional wisdom about these gateway markets in that world?

Joseph L. Pagliari Jr.: So up till COVID, the conventional wisdom was largely that these markets offer less risk than the non-gateway markets. For example, it's often very difficult to build in coastal cities. So reducing the supply side risk is a major advantage for most of these gateway markets. The fact that they are these centers of knowledge production is a favorable comment with regard to demand.

And so, as real estate investors, historically, we've been willing to pay more for buildings in these markets. And when I say more, I mean we are paying lower capitalization rates, or cap rates for short. In the real estate world, a cap rate is more or less equivalent to the earnings-to-price ratio in the stock world. Right? So we're thinking about net operating income divided by price is our cap rate.

It's a measure of current productivity of the dollar invested. And so, generally speaking, capitalization rates for the gateway markets, once you control for different property types, have been about 50 basis points or more below the non-gateway markets. In other words, investors are paying a premium to invest in those gateway markets.

Hal Weitzman: And that's why the rent is so damn high.

Joseph L. Pagliari Jr.: To quote an old mayoral candidate in New York. Yeah. I mean, the rents are a function of supply and demand in each of those markets, and then the next question is, what are investors willing to pay for that rental stream? And again, in these gateway markets, investors are willing to use a lower discount rate, which increases the price.

Hal Weitzman: They just prepare to pay more?

Joseph L. Pagliari Jr.: Pay more because they have believed that they are less risky.

Hal Weitzman: Okay. And so, that was the conventional wisdom.

Joseph L. Pagliari Jr.: Conventional wisdom. Yeah.

Hal Weitzman: So what's changed? You mentioned COVID.

Joseph L. Pagliari Jr.: So COVID came along, and COVID kind of exposed a number of infirmities with regard to these gateway markets. Amongst them is, they tend to have very poor fiscal management. In other words, their balance sheets are dramatically overleveraged, and a lot of that is tied to underfunded pension liabilities to public sector employees.

They also are high-tax cities, counties, and states. So you've got this kind of dual problem of you've got an overleveraged balance sheet, and you have very high taxes. And so, I'm talking about taxes. I'm talking about all the taxes implemented at the state, county, and city level. So you can think about the state income tax, property taxes, gasoline taxes, transfer taxes. The list goes on and on.

But generally speaking, in the gateway markets, taxes are higher than the rest of the country. So you really can't tax your way out of this problem of overleveraged balance sheets that plagues many of the gateway markets. The other side of this is, in corporate finance, we talk about financial distress. So if you run a company that is over-levered, you tend to make suboptimal decisions, because your financing constrains your choices.

It's the same thing for these municipalities. They're over-levered. So they spend less on things like police, firefighting, schools, and infrastructure, which is ultimately bad for commercial real estate, and residential real estate for that matter.

Hal Weitzman: Okay. But just explain that. Well, first of all, the trends that you're talking about, as you have observed and others have observed, go back beyond COVID. So there are some people who say, "Well, COVID changed everything." But in this case, it's-

Joseph L. Pagliari Jr.: Right. I wouldn't say that COVID changed it so much as COVID exposed it. Right? So during this period of fragility, a lot of these cities were kind of exposed as having overleveraged balance sheets and poor services, including policing. So crime, as an example, has tended to go up over the last four or so years. That's kind of a manifestation of having too much leverage, and therefore having to make painful choices about what we spend money on.

Hal Weitzman: Mm-hmm. Okay. And we're talking here about commercial and residential?

Joseph L. Pagliari Jr.: I'm mostly focused on commercial real estate, income-producing properties, but you can draw the clear analogy to single-family homes. Right? So you already see this in some sense with regard to population and voter movement. Right? It's no secret that people have been leaving New York, New Jersey, Illinois, California, high-tax states with difficult balance sheets, home of the gateway markets or some of the gateway markets, for places like Florida, Texas, the Carolinas that have a lower tax burden and a lower regulatory burden.

Hal Weitzman: So what's been happening to commercial real estate prices in those gateway markets?

Joseph L. Pagliari Jr.: So in those gateway markets, relative to the non-gateway markets, there has been a kind of leveling, if you will. So that 50-basis-point spread I talked about before is generally narrowing. And in some cases, Chicago would be an example of this, it's maybe gone from a 50-basis-point discount to a 25-basis-point premium, meaning that investors, particularly with regard to Chicago, are very concerned about the direction of property taxes as one example.

So just as an aside, a few years ago, somebody asked me to run an analysis looking at the value of buildings in downtown Chicago. So in round numbers, the buildings in downtown Chicago pay about 35% of the property taxes for the entire city. If the value of those downtown buildings, primarily office buildings, goes down by 40% due to COVID, work from home, and all the rest, which is not an implausible number, then the tax burden gets shifted to the rest of Chicago, and the tax rate on the rest of Chicago's properties have to go up by 20% to offset the 40% decline in downtown properties.

Now, that's probably politically unpalatable. So as a result of that, the mayor's office and other city officials will probably have to cut back further on services. Right? So there's this teeter-totter, if you will, between how high we raise taxes and how much we cut services, just as a political reality.

Hal Weitzman: I mean, one of the things that happened since COVID is this acceleration in working from home. So obviously, that's affected. Talk about how that's fed into this pricing.

Joseph L. Pagliari Jr.: Yeah. So the work-from-home phenomenon, which probably would have happened had it not been for COVID, in other words, a vast number of white-collar corporations decided, "Hey, let's try this work-from-home experiment," wouldn't have happened without COVID in all likelihood, and many, many employees decided or found out that they really enjoy the benefits of working from home.

And I think it's particularly true if you're a young parent. Right? The ability to kind of manipulate where and when you're going to be certain places is a huge advantage. So in any event, the demand for office buildings in downtown city centers dropped as a result of that. These are huge fixed assets. So if the demand drops, rents have to drop, and therefore, values have to drop. And so, that's kind of where we're at with regard to most all big urban cities.

New York and San Francisco are two really good examples of this, because they have huge concentrations of downtown office buildings. I looked it up the other day, something like the top 10 office buildings in New York pay half a billion dollars a year in property taxes. The top 100 office buildings in New York pay approximately $2.25 billion a year in property taxes. That's a huge element of the municipal budget. And if that drops roughly in half, just to make the math easy for a second, that has all kinds of downstream ramifications for the citizenry, of course, as well as for commercial real estate investors.

Hal Weitzman: But this difficult financial situation, as you said, has been going on for a long time, and we are sitting here in the city of Chicago, which has had financial... I mean, it's basically been living in a financial crisis as long as I've lived here, which is since 2007. So it's nothing new, but it's accelerated, and how much of that is to do with this drop in demand because of working from home?

Joseph L. Pagliari Jr.: It's a huge problem with regard to the revenue side of the equation for these municipalities, because now, the property taxes are going down with regard to these office buildings. The answer historically has been to raise property taxes on all the other buildings. Right? In some sense, it's a zero-sum game. So that's kind of true on the revenue side if you look at it from the standpoint of a government entity.

On the expense side, their pension liabilities are exploding. So they've made all these promises to teachers, police officers, firefighters, and the like, for the most part, all unionized, and it's kind of a, "Let's kick the financial can down the road and have future generations pay for the obligation." And that obligation is kind of mushrooming, and that's a huge part of the financial problem.

Hal Weitzman: Okay. So this is looking into the future. We see risk, and that's something that obviously is going to be on the mind of institutional real estate investors.

Joseph L. Pagliari Jr.: Right. Right. And the risk again is, just to be clear, increasing property taxes and declining services. Both of those things are very bad for real estate, commercial or residential.

Hal Weitzman: So, I mean, as much as you know, I mean, how are institutional real estate investors now thinking about these gateway markets?

Joseph L. Pagliari Jr.: So some investors have redlined Chicago, meaning that they refuse to invest dollars here until there's a clearer financial picture, because the other part of it, besides increasing taxes and declining services, is just the risk of not knowing which direction this is going to take. Right? So just in terms of a risk premium, the discount rate has to go up, and therefore lower prices.

Hal Weitzman: Okay. So if, from a real estate investing perspective, these gateway markets are so unattractive or less attractive than they were, why are the house/home prices still going up in these markets?

Joseph L. Pagliari Jr.: For the most part, construction of new homes is very muted. So we have a situation where demand is growing, supply is fixed, and the obvious economic answer is prices have to go up. And Chicago's actually done fairly well in the last couple of years as compared to the national averages for exactly that reason. More or less, fixed supply, very little new supply, and somewhat growing demand, as opposed to, you can think about some of the Sunbelt markets where it's very easy to build. Right? There's lots of land. There's not much regulation. Their supply and demand are in much better equilibrium.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show that you should check out. It's called Nine Questions. Join Professor Eric Oliver as he poses the nine most essential questions for knowing yourself to some of humanity's wisest, the most interesting people. Nine Questions with Eric Oliver, part of the University of Chicago Podcast Network.

Joe Pagliari, in the first half, we talked about your research about real estate, commercial real estate, and gateway markets, and you talked about some of the challenges these cities have had in terms of their fiscal situation. But there's another aspect to this as well as tax and the financial crises that's going on then in these cities. You talked about regulation as another friction, as economists would say, that kind of works like a tariff. Explain what you were talking about there.

Joseph L. Pagliari Jr.: Yeah. So generally, the gateway cities are Democrat-controlled cities and have been so for a long period of time. And generally speaking, in those Democrat-controlled cities, there's a high level of regulation. The regulatory burden is particularly difficult for small companies. So as an aside, Ezra Klein and Derek Thompson have written a book called Abundance, and they talk about this very problem, which is, generally speaking, the Democrat Party is more prone to process and regulation than is the Republican Party, and you can make whatever political stand you want about it.

The point is, with regard to commercial real estate investing, the higher regulations impose a particularly high burden on small companies. They can't afford the same number of lawyers, accountants, lobbyists, and all the rest that big corporations do. So small companies tend to look elsewhere, and small companies generally are the engines of growth. Right? We generally have more job growth from small companies than we do large companies. And so, that's yet another problem facing many of the gateway markets.

Hal Weitzman: What are the kind of regulations you have in mind that are particularly-

Joseph L. Pagliari Jr.: Business formation, tax reporting, perhaps it's diversity requirements. It's a host of regulations that slow down the gears of progress.

Hal Weitzman: And you say they work like a tariff. How so?

Joseph L. Pagliari Jr.: They're another form of a tax. Right? And I think you've said it in your opening remarks. That is to say, it's a cost of doing business. That's unavoidable. But in a sense, it's a regressive tax, because it's more burdensome to the small companies as opposed to the large companies.

Hal Weitzman: Mm-hmm. Now, you also talk about bureaucracy, which I guess goes somewhat hand in hand with regulation.

Joseph L. Pagliari Jr.: Yes. Right. Right. Right.

Hal Weitzman: Right? The more regulation you have, the more people you need to regulate, and how a high level of bureaucracy, government bureaucracy, at the local level favors large, incumbent firms and kind of stifles startups, and you talked a little bit about how that ladders up into economic growth. Just tell us a bit more about that.

Joseph L. Pagliari Jr.: So it's really the same problem, which is to say that the large companies can afford to overcome these regulatory burdens. They have the critical mass to do so. The small companies do not. And so, the small companies relocate elsewhere. Therefore, the job growth is elsewhere. That is to say, outside of the gateway markets, which, again, is a problem for commercial real estate investors in those gateway markets. If you look at the job growth statistics, for example, in many of these gateway markets, they pale in comparison to the non-gateway cities.

Hal Weitzman: Okay. So there's another aspect that I want to dig into here, which is something, again, we're familiar with in Chicago. Just political corruption. So you say there's more political corruption in gateway market states, not necessarily in the cities, in terms of federal corruption convictions per capita. Tell us about that.

Joseph L. Pagliari Jr.: Yeah. So if you just look at the data... And the reason that we look at federal corruption cases is, at the state, city, and county level, there can be some manipulation. Right? There can be a bit of an old boys' network, and things don't get prosecuted. Right? At the federal level, it's less true. And the data suggests that in the gateway markets or gateway states, the level of corruption is higher. I think it's due to two things.

One, for the most part, these gateway markets have been controlled by one political party for a long period of time. When only one party is in charge, I think that leads to a certain amount of, oh, I don't know, sloppiness with regard to ethical behavior. Right? The second part of it is, in high-tax, high-spend states, the rewards to corruption, the rewards to lobbying are much higher than in low-tax, low-spend states. So you've got this double combination of one party in charge for a long period of time, the prize being much bigger. It leads to more corruption.

Hal Weitzman: And that's interesting, because obviously, the United States is becoming more polarized. And so, the state houses are, well, presumably, over time, become more and more one party-like. And is that why you say that that system favors incumbents, because they have the dollars and the connections?

Joseph L. Pagliari Jr.: They do. And I can't quote the rate of incumbents who win their elections, but it's a really high percentage, and that one-party view. So say it the other way. Without a change of party, there isn't the same set of new, fresh eyes looking at what the previous administration had done with regard to ethical behavior. There's kind of a go-along, get-along kind of-

Hal Weitzman: But it's not necessarily a Democrat/Republican thing.

Joseph L. Pagliari Jr.: No, no.

Hal Weitzman: You're saying it's anywhere where you've had one party.

Joseph L. Pagliari Jr.: Yeah. It tends to be found, again, where you've had one party for a long period of time, and number two, the rewards to corruption are high. It tends to be in the big-spend states. The big-spend states tend to be Democratic.

Hal Weitzman: Okay. So let's talk about, and you referred a little bit to this earlier, where people are going if investors are shying away. They're recalculating their risk appetite for gateway markets. They're going to non-gateway markets. Talk about some of those. Where are they, and what are the characteristics of those?

Joseph L. Pagliari Jr.: So you can think about Seattle, Denver, Houston, Dallas, Nashville, Miami. These are all growing metropolitan areas. They don't tend to have the same legacy problems that the old cities like Chicago, New York, Boston, we didn't talk about them, but Philadelphia, Cleveland, and the like. There's a lot of growth there.

And so, they tend not to have the same poor balance sheets. They tend to have lower tax rates. And so, those things are generally perceived to be favorable from a commercial real estate investing perspective. I would say, on the other hand, those markets are experiencing a lot of growth, and how they manage that growth. More schools, more hospitals, more roads and bridges, more police officers, more firefighters. That is not an easy thing necessarily, and some of those markets are going to handle that growth better than others.

Hal Weitzman: Okay. So you mentioned Seattle, which is not a... I mean, the others, I think, are perhaps more Republican-leaning, but just-

Joseph L. Pagliari Jr.: Denver is kind of-

Hal Weitzman: Denver? Of course. Sure. So, I mean, again, to reiterate that point, it's not necessarily a political-leaning thing.

Joseph L. Pagliari Jr.: No. Right. Right. I'm not trying to say blue versus red is kind of the defining metric with regard to how you should think about allocating your real estate dollar. I am trying to suggest that you should look at the fiscal situation of each of these municipalities, their regulatory burden, their tax structure, and make a decision about whether or not you're getting adequately compensated for the risks you're about to take as an investor.

Hal Weitzman: But ultimately, what is driving this is demand. People are deciding they would rather, and presumably a lot of them young people early on in their careers, is that they would rather move to these and raise a family in these cities than in the older gateway cities that you-

Joseph L. Pagliari Jr.: Yup. And some of it has to do with affordability. Right? It's very difficult to live and work in Manhattan, as one example, on one income. Almost impossible, I would argue, if you're a younger person, to your point. And so, people make the calculation, "Maybe I'll look elsewhere to work."

Hal Weitzman: Okay. I mean, it's interesting, because living in Chicago, and this is true of many places, there are often threats from companies and individuals. We have billionaires leaving Chicago, very high-profile cases.

Joseph L. Pagliari Jr.: Yeah. Ken Griffin is a good example.

Hal Weitzman: There you go. And we've had companies that, many cases, threaten and don't actually pull the trigger and get some kind of benefit for staying.

Joseph L. Pagliari Jr.: That's right. I mean, I think the element of that that is often overlooked is that city officials recognize it's going to be a huge loss to lose ABC company. So they give ABC company some kind of preferential treatment, a reduction in property taxes or whatever the case might be, which is fine, and maybe it was a good investment, but that decreased tax burden falls on everybody else.

Hal Weitzman: Right. And it makes the system even more complicated, because everyone has individual arrangements. Right?

Joseph L. Pagliari Jr.: Right. Yeah.

Hal Weitzman: Yeah. Okay. I mean, the other thing that's a bigger trend, we talked about remote work. And in your research, you talk about an urban doom loop.

Joseph L. Pagliari Jr.: Yup. I wasn't the first to coin that phrase, but yes. So this whole potential downward spiral, maybe without a bottom to it, is causing a lot of investors to be concerned with regard to these gateway markets that, in some sense, most evidence this urban doom loop, and a lot of it has to do with a concentration of office buildings downtown.

So before COVID, office buildings were kind of the prized assets from a municipality standpoint. Pay a lot in property taxes, as I mentioned before, and demand almost no services. They don't have kids going to school. They pick up their own trash. They shovel their own sidewalks and parking lots. It's kind of a win-win, up till COVID, for these municipalities to have these gigantic downtown office buildings, and that calculation has changed given what's transpired since.

Hal Weitzman: So the other big trend apart from remote work is climate change, of course, and that there's been a lot of data that I've seen saying that the risks of climate change are not priced in, that coastal cities are still popular, at least on the residential side. What's happening on the commercial side?

Joseph L. Pagliari Jr.: Yeah. I think on the commercial side, there is much more attention to climate change. I think, generally, it's priced in. If you believe, for example, that the oceans are going to rise and that's going to cause coastal damage, you can kind of draw a line from New England down through the Carolinas, wrap around Florida, go through the Gulf, and get to Texas.

And so, all those properties near the ocean in those markets may be subject to some kind of risk. I think you see that being priced not only by commercial real estate investors, but also by the insurance companies that insure them. So as I got into it, I'm less concerned about climate change being a mispriced risk. My view is, as an active investor, you have to think about what is mispriced.

And I think there's still some hesitancy to fully consider the devastating effects of these poor balance sheets at many municipalities in the gateway markets, coupled with their high taxes, high regulation, high crime, corruption, and the like.

Hal Weitzman: So are we going to see a big move, do you think, a continuing move in population away from gateway cities and toward these other cities?

Joseph L. Pagliari Jr.: I'm reluctant to say it's going to be a big move. I think that, for me, the big move is going to be with regard to pricing by institutional investors in these gateway markets. These gateway markets are still generally robust markets with regard to knowledge, job creation, business growth, and the like. The question is, what price do I have to pay for that as a real estate investor? And right now, the price seems a little bit too high, given all the risks.

Hal Weitzman: All right. Well, Joe Pagliari, thank you so much for coming on the Chicago Booth Review Podcast.

Joseph L. Pagliari Jr.: Thank you.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research. This episode was produced by Josh Stunkel. If you've enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.